Chapter 4:

Options

4.1 Mechanics and properties of options

4.1.1 Mechanics of options
4.1.2 Properties of options
4.2 Trading strategies involving options
4.2.1 Trading an option and the underlying asset
4.2.2 Combinations and spreads

1
4.1 Mechanics and properties of options

4.1.1 Mechanics of options

Whereas forwards, futures, and swaps commit the holder to the obligation to do
something, the option gives the holder the right to do something. The holder
does not have to exercise this right.

► Definitions

■ There are two types of options : calls and puts

→ A call option gives the holder the right to buy the underlying asset by a certain
date (known as the strike date or maturity) for a certain price (known as the
strike price or exercise price).
→ A put option gives the holder the right to sell the underlying asset by a certain
date (known as the strike date or maturity) for a certain price (known as the
strike price or exercise price).

■ American and European options

American options can be exercised at any time up to the expiration date.
European options can be exercised only on the expiration date 2
■ important notice
→ The buyer of an option holds a right. He will exercise his right if it is his interest
to do so.
→ The seller of an option (also called the writer of the option) is dependant of the
decision of the buyer : if the buyer exercises his right the seller is obliged to comply
with the terms of the option

■ Understanding the quotes of options : the premium

On 19th Nov N Poti Ltd quoted 53.22 EUR. Hereafter quotes on American calls
and puts on Poti Ltd in Euronext.
→ The price of a call decreases as the strike price increases, while the price of a put
option increases as the strike price increases.
→ Both types of option tend to become more valuable as their time to
maturity increases.
CALL PUT
Dec-N Jan-N+1 Strike price Dec-N Jan-N+1
- - 50 0,93 1,6
2,38 - 52 1,37 2,33
- 2,26 54 - -
0,82 1,45 56 3,9 - 3
 4.1.2 Properties of options

► Payoffs of elementary positions on options (K =strike price, S =underlying

asset spot price, c = call premium, p = put premium)
→ Long call → Short call
Payoff = max(S-K, 0) - c Payoff = c - max(S-K, 0)

 +1  −1
0 0
  K c  
S S
-c K

→ Long put → Short put

Payoff = max(K-S, 0) - p Payoff = p - max(K-S, 0)

0 0
 +1 p  −1
  K  
S S
-p K
4
► total value of an option
Total value of an option is the sum of its intrinsic value and its time value

■ The intrinsic value of an option is defined as the maximum of zero and the value
the option would have if it were exercised immediately.
→ for a call option, the intrinsic value is therefore max(S - K; 0)
A call option is referred to as ‘in the money’ when S > K, ‘at the money’ when S =
K, and ‘out of the money’ when S < K
→ for a put option, it is max(K - S; 0)
A put option is referred to as ‘in the money’ when S < K, ‘at the money’ when S =
K, and ‘out of the money’ when S > K

■ The time value of an option is the remaining of the value, the value coming from
waiting rather than exercising immediately
→ for a call option, the time value is c - max(S - K; 0)
→ for a put option, it is p - max(K - S; 0)

5
→ Application : American options on stock Poti_Ltd traded on July 15 N for
August and September expiration dates, as share price quoted 53.35

Strike CALL PUT

Aug Sep Aug Sep
50 4,13 4,74 0,74 1,3
52 2,75 3,41 1,36 1,97
54 1,69 2,34 2,3 2,9
56 0,92 1,49 3,52 4,04

Intrinsic values of options Time values of options

Strike CALL PUT Strike CALL PUT
Aug Sep Aug Sep Aug Sep Aug Sep
50 3,35 3,35 0 0 50 0,78 1,39 0,74 1,3
52 1,35 1,35 0 0 52 1,4 2,06 1,36 1,97
54 0 0 0,65 0,65 54 1,69 2,34 1,65 2,25
56 0 0 2,65 2,65 56 0,92 1,49 0,87 1,39

6
4.2 Trading strategies involving options

4.2.1 Trading an option and the underlying asset

► protective put strategy

Buying the stock and a put option on the stock  +1  0   +1
 −1 +  +1 =  0 
Payoff = S – S0 + max(K-S, 0) –p      

7
4.2.2 Combinations and spreads

► Combinations
A combination is an option trading strategy that involves taking a position in
both calls and puts on the same stock.

■ straddle
A straddle involves buying a European call and put with the same strike price
and expiration date.

Payoff = max(S-K, 0) –c + max(K-S, 0) -p

 +1  0   +1
 0  +  +1 =  +1
     

8
■ strips and straps
→ A strip consists of a long position in one European call and two European puts
with the same strike price and expiration date.
Payoff strip = max(S-K, 0) –c + 2[max(K-S, 0) –p]

→ A strap consists of a long position in two European calls and one European put
with the same strike price and expiration date
Payoff strap = 2[max(S-K, 0) –c] + max(K-S, 0) –p
 +1  0   +1
 0  +  +1 =  +1
     

9
■ strangle
A strangle involves buying a European put and a European call with the same
expiration date and different strike prices. The call strike price, K2, is higher
than the put strike price, K1

Payoff = max(S-K2, 0) –c + max(K1-S, 0) –p

 +1  0   +1
 0  +  +1 =  +1
     

10
► spreads
A spread trading strategy involves taking a position in two or more options of the same
type (i.e. two or more calls, or two or more puts)

■ butterfly spreads
A butterfly spread involves positions in options with three different strike prices. It can
be created by buying a European call with a relatively low strike price K1,buying a
European call with a relatively high strike price K3, and selling two European calls with
a strike price K2 that is halfway between K1 and K3.

Payoff = max(S-K1, 0) – c1+ max(S-K3, 0) – c3 +2[c2 – max(S-K2, 0)]

 +1  −1 0 
 0  +  0  = 0 
     

11